Ch. 14 Corporate Tax Anti-avoidance Rules

11/24/2015 (c) William P. Streng 1

Ch. 14 Corporate Tax

Anti-avoidance Rules

In the U.S. corporate income tax context U.S.

Treasury Department has concerns about:

1) Avoidance of the double tax on

corporate/shareholder taxation.

2) Avoiding high marginal tax rates for individuals,

including through the use of corporate entities.

3) The significant reduction of corporate tax

liabilities through corporate tax shelters, and

similar arrangements (e.g., leasing arrangements).


Anti-Avoidance Rules in

this Chapter 14

1) Economic substance doctrine – tax common law

doctrine transformed into a statutory provision.

2) Accumulated earnings tax – p.626.

Penalty tax is imposed when a corporation is

“availed of” to avoid the shareholder level tax.

Individual rates are higher than corporate rates.

3) Personal holding company tax – p. 645. Can

not use a corporation as one’s individual

“pocketbook” (& accumulate income in a corp.

taxed at a lesser income tax rate).


Corporate Tax Shelters

Basic Premises p.611

1) Realize a tax loss without an economic loss.

2) Income is deflected to a “tax-indifferent party.”

3) Exploit Code language ambiguities.

4) Secrecy of the deals/Confidentiality

requirements are imposed on the deal.

5) Differences between tax & financial accounting.

6) Tax counsel “reasoned (?) opinions.”

Plus: exploit the “audit lottery.”


Prior Attempts to Limit

Corporate Tax Shelters

1) IRS litigation strategy (case-by-case).

2) Disclosure of tax shelter investments required,

including the registration of tax shelters. See IRS

Notice 2009-59 with a list of tax shelters.

3) An increased no fault “substantial

understatement” penalty.

4) Penalties for failure to disclose.

5) Enhanced requirements on the conduct of

professionals re opinions. Treasury Circular 230.


UPS case, 11th

Cir. p.612

Economic substance?

UPS organized offshore subsidiary (OPL) to

provide reinsurance for excess value insurance on

shipments. Why use National Union in the deal?

OPL shares were distributed to UPS shareholders.

Issue re whose income for the “excess value” net

amount - economically realized by OPL or UPS?

Real economic substance to this arrangement?

Held: Not a “sham” transaction; adequate business

purpose existed; but, is §482 applicable? P.616.

continued


UPS case, continued p.612

Economic substance?

Dissent: Was there any legitimate, substantive

business reason?

Tax Court decision that subjective motivation was

tax avoidance. Plus, not real economic or business

purpose. Only for tax avoidance purposes.

Plus, OPL was charging an inflated rate for its

services.

See earlier §482 discussion at p. 592 in casebook.


Economic Substance

doctrine p.619

1) Economic substance doctrine: Transactions are

to have “economic substance” separate and apart

from the economic benefit achieved merely from

the income tax reduction obtained. A meaningful

change to the taxpayer’s economic position must

occur.

2) Business purpose doctrine (p.619): was a non-

tax objective sought to be achieved?

Are both requirements to be satisfied? P.620

continued


Economic Substance

doctrine, cont. p.620

Do financial accounting (i.e., GAAP) benefits

provide a non-tax business purpose? No. P.621

Consider the relevance of “tax-indifferent” parties

as being included in a transaction. What/who is a

“tax indifferent” party?

Ultimate question: Does this transaction satisfy the

“economic substance doctrine”? P.621


Economic Substance

Doctrine Codified p.622

§7701(o) is entitled a “clarification” of economic

substance doctrine, i.e., a “common law” doctrine.

A transaction has “economic substance” only if (1)

transaction changes in a meaningful way the

taxpayer’s economic position, and (2) the taxpayer

has a substantial purpose (apart from Federal

income tax effects) for entering into such

transaction. Code §7701(o)(1).

I.e, the “conjunctive test” applies.


Economic Substance

Doctrine Codified, cont.

§7701(o)(2)(A) – a pre-tax profit potential is to be

substantial in relation to the present value of the

expected net tax benefits.

§7701(o)(2)(B) – Transaction expenses are to be

taken into account as expenses in determining pre-

tax profit.

And, a financial accounting benefit is not taken

into account for legitimating the transaction.

§7701(o)(4).


The Protected “Angel List”

p.624

- Debt v. equity.

- Domestic or foreign entity.

- Corporate organization or reorganization.

- Related party transactions (outside §482).

Plus, use of specific statutory tax incentives.

But, IRS does not confirm this listing.

And, no private letter rulings are issued. Notice

2010-62 and Notice 2014-58.


Problem

p.625

Proceeding with a corporate acquisition

transaction structured as a stock-for-stock

exchange but (1) with minimal cash included so as

to frustrate “B” reorg. status, and (2) therefore,

trigger loss on Target stock to get the tax benefit of

an accrued loss on the stock being transferred.

Is this structured “failed B reorg” transaction

subject to, and is loss utilization limited by,

applicability of the “economic substance” doctrine?


Problem, cont.

The “Busted B” P.625

(a) Is the “economic substance” doctrine even

relevant here? See §7701(o)(5)(C).

Is the relevancy of this doctrine determined on

whether §7701(o) is applicable in a pre-enactment

situation?

If not applicable, then, the “no boot in a “B” rule”

should be controlling and loss realization should be

recognized (the economic substance doctrine then

not being relevant).


Problem, cont., Part (b)


(b) Assuming the “economic substance” doctrine is

relevant here: If so, then how apply the two tests –

1) Was there a meaningful change in the taxpayer’s

economic position? and,

2) Did the taxpayer have a substantial non-tax

purpose for entering into this transaction?

Desire to recognize a tax loss existed; there was a

meaningful change in economic position; economic

loss existed before the transaction. But, could have

sold the stock for cash. continued


Problem, Part (b), cont.


Should this transaction be on a deemed acceptable

transaction “angel list” (see JCT report), since

taxpayers should be able to structure transactions

as complying with (or not) various statutory

provisions (e.g., 351, 368, 332, 1031, and other

Code non-recognition provisions).

Conclusion: This is not the type of transaction

intended to be penalized through the enactment of

§7701(o).


Accumulated Earnings Tax

“C” Corporations p. 626

Issue: Can a corporation be used as the temporary

location for assets after incurring a (lower)

corporate tax rate and before (if at all) incurring a

second, higher income tax rate for shareholders?

Incentive to avoid applicability of accumulated

earnings tax by stripping earnings from a

corporation on a tax deductible basis (e.g.,

compensation and fringe benefits)?

Wait for a redemption transaction to extract

earnings on a low taxed basis (i.e., capital gains)?


Accumulated Earnings Tax

Imposition p. 627

Tax is imposed at 20 percent of the C corporation’s

“accumulated taxable income.”

Accumulated earnings credit (offset) of up to

$250, 000 (Code § 535(c)(2)); limited to $150,000

for personal service corporations.

Retention of “accumulated taxable income” in

determining evidence of purpose to avoid income

tax. Code §§ 533 and 537.

Is AET applicable to publicly held corporations?


Identifying Reasonable

Need of the Business p.630

Myron’s Enterprises, p. 630 – determining the

amount necessary to be retained for the

“reasonable needs of the business.”

Held: all accumulations for “reasonable needs.”

Reasonably anticipated needs included the funds to

buy the building where the business was located.

Did a specific, feasible plan exist?

Need not consider the capacity of shareholder to

lend to the corporation.


Reasonable Needs of the

Business p.635

1) Expansion of plant or equipment.

2) Make business purchase (stock or assets).

3) Retire corporate debt.

4) Working capital for the business.

5) Customer & supplier financial support.

Not for loans to insiders and for unrelated passive

investments by the corporation.


Concept of “Working

Capital” p.637

Bardahl formula: How much capital is needed to

cover one operating cycle?

Cycle includes (1) purchase of raw materials, (2)

processing into finished goods, (3) selling the

product, and (4) collecting on accounts receivable.

What if a delay in paying the payables (e.g., for

raw materials)? Reduce the length of the operating

cycel?


Gazette Publishing Co.

p.639

Retained funds were used to purchase stock at an

excessive price so that stock was not acquired by

outsiders.

Holding: diversion of accumulated earnings for

this purpose did not reflect an unreasonable

accumulation.


Problems p.644

(a) Annual retention of earnings to finance

expansion of its manufacturing plant. But, could

have borrowed funds to this expansion.

Result: Reasonable needs requirement satisfied,

but must have reasonable definitive plans.

(b) Manufacturing corporation accumulates funds

to buy/net lease a building to an insurance co.

Result: Probably not an active business. See Reg.

§1.537-3(a) which does permit retention for any

business.


Problems p.644

(c) Parent’s retention of earnings to assist related

corporations. Result: OK to accumulate for active

business subsidiary only. Reg. §1.537-3(b).

(d) Accumulation of funds for potential §531

liability. Result: Not for the reasonable needs of

the business. But, if accumulating for this purpose,

an “admission against interest” when a §531

challenge?


Problems p.644

(e) Accumulation of funds to redeem a class of

limited and preferred stock. Result: Not a

reasonable need of the business, subject to an

exception for a §303 redemption.

See §537(b)(1) or (2).


Problem 2 – Accumulated

Earnings Tax Amount p.645

E&P (year 1) of $200,000. Then taxable income of

$60,000 for years 2, 3 & 4.

(a) Tax results: Minimum credit of $250,000.

Year three – over $250,000 base.

(b) Defenses – assert reasonable needs of the

business.

(c) §534 impact? Shift the burden of proof to IRS.


Personal Holding Company

Tax p.645

Special tax to preclude:

1) “Incorporated pocketbooks”

2) Incorporated talent

3) Incorporated properties – subject to a lease to

shelter lease income which is deducted by the

shareholder tenant payor.



Definition p.646

Stock ownership requirement - §§ 542(a)(2) & 544.

Definition: PHC status if more than 50 percent in

value of the corporation’s outstanding stock is

owned by or for note more than five individuals.

Attribution of ownership rules (under §544(a)) are

applicable to determine this ownership.



Definition p.646

Income test - §542(a)(1) & §543.

At least 60 percent of the corporation’s adjusted

ordinary gross income must be “personal holding

company income.”

What is personal holding company income?

Passive income such as dividends interest,

annuities, royalties and rental income (but only if

being less that 50 percent of total gross income).

& certain services income.


Rev. Rul. 75-67 p.652

§543(a)(7) specifies that PHC income includes

certain income received under a personal service

contract – if some other person has the right to

designate the individual to perform the services.

Physician-patient relationship does not constitute

such a designation, unless the physician has no

right to substitute the performer.

Consider the contract with the specialist heart

surgeon.


Rev. Rul. 84-137 p.653

Corporate lessor and corporate lessee and both

corporation are owned by the same individual.

Is the rent PHC income?

§543(a)(6)(A) – PHC income where lessor corp. at

least 25% owned by individual who can use the

property. And, only (§543(a)(6)(B)) where lessor

corporation has PHC income exceeding 10% of its

ordinary gross income. Not applicable where corp.

to corp. lease arrangement & property used in

trade or business.


The PHC Tax Structure

p.655

1) Adjustments to taxable income. PHC taxed

based on after-tax income. Deduction from PHC

tax base for certain payment, e.g., federal income

taxes.

2) Dividends paid deduction – PHC tax not

applicable to distributed earnings. Includes actual

dividends and consent dividends & deficiency

dividends.



Tax – Problem 1 p.658

PHC status?

a) Not a PHC since income from active business.

b) $30,000 of PHC income. Note: even

manufacturing companies can be caught in the

PHC net.

c) §1231 gain not included for this purpose.

§543(b)(1)(B). §1245 gain is included. But, PHC

income is less than 60% of AOGI.




PHC status?

a) All corporation’s income is PHC income.

§543(a)(7).

b) Attempt to increase gross income to get to

below 60% of adjusted ordinary gross income.




PHC status?

a)




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Ch. 14 Corporate Tax Anti-avoidance Rules